Working Paper: CEPR ID: DP586
Authors: William H. Branson
Abstract: As the European Community (EC) unifies its financial markets and fixes its exchange rates, the EFTA countries are liberalizing capital movements to the same extent. The EFTA countries thus face a decision on financial markets and exchange rate policy: should they essentially join the European Monetary System (EMS) or should they maintain independent currencies with alternative exchange rate policies? This paper begins by assuming that the EFTA countries align themselves with the EMS and join the unified European financial markets. We then review the constraints this decision would place on current account financing and on monetary policy. Then we question the assumption by introducing three alternatives: an active exchange rate policy that aims at price level stability, an alternative basket to the European Currency Unit (ECU) for a fixed peg, and gradual adjustment of the real exchange rate against the basket. We conclude that all three would be inferior to EMS membership.
Keywords: exchange rate; European Free Trade Area; European Monetary System
JEL Codes: F31; F33; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| EMS membership (J60) | constraints on current account financing (F32) |
| EMS membership (J60) | constraints on monetary policy (E52) |
| maintaining independent currencies (F36) | inferior economic outcomes (F61) |
| EMS membership (J60) | economic stability (E63) |
| EMS membership (J60) | reduction of exchange rate risks (F31) |
| active exchange rate policy aimed at price stability (E63) | inferior outcomes (I14) |
| alternative basket to ECU for a fixed peg (F31) | inferior outcomes (I14) |
| gradual adjustment of the real exchange rate against the basket (F31) | inferior outcomes (I14) |
| integration of European financial markets (F30) | adherence to the EMS (I18) |